Determining Your Allocation at Retirement

The AAII Journal articles on retirement allocation by Jerome Clark and Josh Cohen present different strategies for the amount of stocks and bonds an investor should hold at retirement. Specifically, they disagree on whether investors should immediately increase their fixed-income holdings at retirement (termed the “to” strategy) or gradually increase their fixed-income holdings throughout their retirement years (the “through” strategy).

The disagreement centers around the impact a bear market can have on one’s portfolio. As John Markese pointed out in “Taking Aim at Your Retirement: A Look at Target Date Mutual Funds” (June 2009 AAII Journal), withdrawing money from a stock portfolio at the beginning of retirement when stock prices are depressed can have lasting negative implications on how long your money will last. This is particularly the case when the withdrawals are expected to be made over a shorter versus a longer time period.

Given this, it is important to be aware that Clark and Cohen used different time horizons for their studies. Clark assumed withdrawals will be made over a 30-year time horizon. Cohen opted for a shorter 20-year time horizon. However, it is not just Clark and Cohen who disagree on time horizons. As Markese pointed out, target date funds differ significantly on when, relative to the target date, the portfolio is moved to the final allocation.

So, which is the better strategy at retirement: gradually increase exposure to bonds beyond the date of retirement, or immediately increase the fixed-income allocation at the date of retirement? The answer depends on your personal situation.

How Much Did You Save?

One of the key aspects of retirement planning is how much money was saved prior to retirement. Clark’s article showed that following a more aggressive strategy during one’s working years resulted in a bigger nest egg at retirement than a more conservative strategy. The larger savings, in turn, significantly increased the probability of having enough money to last through a 30-year retirement period, assuming 4% annual inflation-adjusted withdrawals.

If the level of savings and requirements for income dictate a higher withdrawal percentage, the risks of running out of money rise significantly. Cohen calculated that an aggressive 6% withdrawal rate results in only a 42% probability of preserving savings for a 20-year period, even with a higher equity allocation of 60%.

The key point here is that retirement allocation strategies start before an investor retires. The greater the amount saved, the higher the probability that the wealth will last throughout retirement.

What Are Your Income Needs?

The next step is to determine your income needs in retirement. Specifically, what percentage of your portfolio will you need to withdraw on an annual basis and how long do you expect to make those withdrawals?

Both Clark and Cohen used a 4% withdrawal rate, with the annual income requirements adjusted upward for inflation. This means, over time, the actual dollar amounts withdrawn from the portfolio will increase.

Other factors to consider are health and expected longevity. A 65-year old with few health problems and parents who lived well into their 90s may need to rely on their savings for a longer period of time.

Inheritance and Charitable Gifts

Neither Clark nor Cohen discussed situations when assets are expected to exceed the income requirements of the retiree. Such investors face both the need for short-term income and the desire to continue building long-term wealth—to be given to family, charity or both. In such situations, two strategies for managing a portfolio should be considered.

The first is to designate the portion of your portfolio needed for retirement expenses. The allocation strategy for this portfolio would be more conservative, with a greater emphasis on bonds and income generation. A gradual increase in bond allocations, as opposed to abrupt change, can more easily be followed since the overall level of savings significantly exceeds projected income requirements.

The second is to designate a portion of your portfolio for long-term wealth. A more aggressive allocation, meaning a higher percentage invested in stocks, should be followed since there are no short-term income requirements.

Consider Your Individual Needs

There is no strategy for retirement allocation that universally applies to all investors. The best place to start is to determine your needs—specifically, when you will need the withdrawals, how much income will be required, how long the income will be needed and how much you have saved. You can then start to determine your allocation strategy.

This post was taken from an article by Charles Rotblut, CFA, for the July 2010 issue of the AAII Journal.

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Wayne A. Thorp, CFA, is the senior financial analyst and a vice president at AAII. He has written extensively on the topics of technical analysis, quantitative stock selection, stock valuation and analysis, and technology. He is the program manager for Stock Investor Pro, AAII's fundamental stock screening and research database programs. Wayne is also the lead analyst and product manager for AAII's Stock Superstars newsletter and serves on the investment committee of the Dividend Investing newsletter. He has worked at AAII since 1997.

5 Replies to “Determining Your Allocation at Retirement”

All very interesting but as noted, everyone’s situation is slightly different so no one of the proposals should be taken as a firm and fixed guideline. Having saved “enough” is certainly good advice but what to do if you have reached retirement and haven’t saved enough?

Looking back almost twenty years after retirement it would have been bad advice to shift to a conservative investment allocation, e.g. mostly bonds. We have maintained an allocation of about 60% equities and 35% bond funds with no plans to change. We are entirely in mutual funds with very little buying/selling other than automatic proportional selling monthly to meet RMD payments and automatic reinvestment of dividends.

To judge how we are doing we maintain a history of assets (year to year), live on RMD’s, SS and small pension. Taxable accounts simply grow. Use one of the free software packages to project end of yr balances in IRA five years ahead as well as projected annual RMD (using estimated 4% rate of return), keep history of projections and compare with actuals as time goes by. We weathered 2003, 2007-2008, and a couple of others as well as the current up/down without panicking.

Our conservative assets are our home, defined benefit pension(adjusted for inflation), and SS. All of our other assets are invested in Growth Stock mutual funds and will remain invested that way until the end of time. What I have found works is: cash in about 5 years of stock and keep in the Pension money market account. In year 3-4, if the market is “HIGH” transfer another 5 years worth. This way you never feel bad during a down market.

Returns by year are only important on a graph or in a table. In the real world what matters is drawdown – how much money is lost in a stock market cycle. The worst-case scenario should encompass 2007 peak to 2009 bottom, which was much worse than the arbitrary period of 2008.